Posts Tagged ‘Revocable Vs. Irrevocable Trusts’

Since all types of trusts have the same four basic components, the main distinguishing features are the manner in which they are created and the purpose for which they are created. These features allow us to differentiate the various types of trusts that exist today. Typically, trusts tend to be classified – or named – in one of three ways. One common classification is a Revocable versus an Irrevocable Trust.

Revocable Trusts vs. Irrevocable Trusts

If the grantor reserves the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is said to be a “revocable trust.” If the grantor gives up the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is an “irrevocable trust.”

Revocable and Irrevocable only applies to Living Trusts:

It is important to note that the revocable vs. irrevocable classification only applies to living trusts. A testamentary trust is always revocable during a testator’s lifetime because a Last Will and Testament cannot become effective until after the testator’s death and after it has been admitted to probate. Once a testator has died and his or her Last Will and Testament has been admitted to probate, the underlying testamentary trust becomes irrevocable because the only person who could revoke it or terminate it is no longer living. So, when we talk about revocable trusts and irrevocable trusts, we’re not talking about testamentary trusts – we’re only talking about living trusts.

Significance of Revocable vs. Irrevocable Trusts:

Simply put, a revocable trust can be amended, revoked, terminated or changed at any time by the grantor. An irrevocable trust cannot be amended, revoked, terminated or changed by the grantor or anyone else once it becomes effective.

That seems obvious, but, how is this significant? If you put some or all of your property into a revocable trust, you can get the property back any time you want. You can also change the terms and conditions upon which some or all of the beneficiaries will receive benefits under the trust. In short, when you create a revocable living trust and transfer some or all of your property to it, you still retain all the “incidents of ownership” to that property. You can sell it, give it away, can change the beneficiaries of that property, and you can determine how the property will be managed and invested while it’s in the trust. In fact, if you really think about it, you don’t give up any rights to your property when you transfer it to a revocable living trust. That’s why you’re still treated as the owner of the property for tax purposes.

Here’s a descriptive analogy. Suppose you have an apple tree in your back yard. If you decide to dig it up and move it to another part of your back yard, have you changed your ownership of the tree? Of course not. You can still eat the apples or sell them if you wish. You can even cut down the tree and use it for firewood if you choose. That’s the essence of tranferring property to a revocable living trust.

An irrevocable living trust is a different story. If you transfer some or all of your property to an irrevocable living trust, you are giving up all your rights to that property. That’s because an irrevocable trust is, by definition, one that you no longer have the right to amend, revoke, terminate or change. In other words, you give up all your rights to any property you transfer to an irrevocable living trust. It’s the same as giving the property to another person with no strings attached.

Using the apple tree analogy, let’s assume that, instead of moving the tree to another part of your back yard, you move it over to your neighbor’s property. Whether you like it or not, the tree now belongs to your neighbor and you can’t go over there and get it back – at least not without your neighbor’s permission. And, guess who owns the apples growing on the tree?

Staying with this analogy for one more minute, who do you think the IRS will go after in each of these scenarios? If you simply move your apple tree to another part of your back yard (i.e., to a revocable trust), the IRS will come after you for its share of the apples. But, if you move the apple tree to your neighbor’s yard, the IRS will be calling on your neighbors.

Reasons to Form an Irrevocable Trust:

If you no longer own the property transferred to an irrevocable trust, why would anyone ever create one? There are actually many reasons for doing so. One common reason is to satisfy a property settlement as a result of a divorce or some other court decree. Many property settlements mandate that certain property be placed in trust, especially when minor children are the intended beneficiaries.

Many elderly persons, who are concerned about the high cost of nursing homes, also transfer their property to an irrevocable trust before they apply for Medicaid (Title XIX) benefits. In order to qualify, the property must be transferred to an irrevocable trust at least 5 years prior to filing the application, and certain other requirements must be met as well. But irrevocable trusts are frequently used by elderly persons in an effort to avoid paying the high cost of a nursing home stay.

High-net-worth individuals also use irrevocable trusts to protect their property from the claims of creditors. Entertainers, professional athletes, doctors, and other high income people are particularly vulnerable to law suits that result in high monetary judgments, and irrevocable trusts (particularly off-shore trusts or other types of asset protection trusts) are often used as a means of insulating property from these types of claims.

Perhaps one of the most common uses for an irrevocable living trust is the avoidance of federal estate taxes. In past years, individuals with large estates were subject to federal estate taxes as high as 55%.

One of the more common techniques to reduce the federal estate tax is to transfer property to an irrevocable trust. Transferring property to an irrevocable trust is the equivalent of making a complete gift of the property, since you don’t have any right to get the property back or to alter or affect its use in any way once the transfer is made. Upon the grantor’s death, the property is not subject to federal estate tax because the grantor no longer owns it.

We should mention, however, that the federal government treats a transfer of property to an irrevocable trust as a gift for federal gift tax purposes. Since the federal gift tax rates are substantially the same as the estate tax rates, it would seem that there is little to be gained by transferring property to an irrevocable trust. But, that is not necessarily the case. For example, property that is appreciating in value is often a good candidate for this type of transfer because the appreciation in value from the date of transfer to the date of death will be exempt from both the federal gift tax and the federal estate tax.

With this concept in mind, there is one type of property that is often placed into an irrevocable trust; i.e., a life insurance policy on the grantor’s life. The death benefit payable upon the death of an insured is subject to federal estate taxes. If your estate is large enough to be subject to the federal estate tax, then owning a life insurance policy on your life will cause the death benefit payable to your designated beneficiaries to be taxed at rates as high as 35%. For example, if you have a $1,000,000 insurance policy on your life and you die owning the policy, then the estate tax payable on that $1,000,000 death benefit will be approximately $350,000 – leaving only $650,000 for your beneficiaries. Of course, this assumes that your estate is larger than the applicable exclusion amount in the year of your death ($5,120,000 for 2012).

This result can be avoided entirely by purchasing the life insurance policy through an irrevocable living trust or by transferring the policy to an irrevocable trust after the trust has been established. Yes, the value of the life insurance policy is considered to be a gift to the trust at the time of the transfer and that value is subject to the federal gift tax. But, what is the value of the policy at the time of the transfer? If it’s a term policy, the value is absolutely zero! If it’s a whole-life policy or any type of policy that builds a cash value, the value of the policy is the cash surrender value (or, more technically, the “interpolated terminal reserve” value) at the time of the transfer. In either case, there will probably be no gift taxes paid on the transfer. Then, upon your death, the entire death proceeds will be estate-tax free because you don’t own the policy. Using our example above, if the $1,000,000 insurance policy on your life is transferred to an irrevocable trust prior to your death, then the entire $1,000,000 would be payable to your beneficiaries and nothing would be payable to the U.S. Treasury – a savings of approximately $460,000.

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